People frequently purchase investment real estate with the belief that they will save some money on their income taxes as a result of their property ownership. And this could be true, but in many cases real estate provides an owner with virtually no tax savings at all. In this article we’ll talk about rental properties and how you can figure out, with your tax advisor, if your real estate ownership will assist you to reduce your annual tax bill.
All annual personal income tax reporting ends with an individual filling out their two page IRS 1040 main tax form. In order to reduce one’s taxes as much as is legally allowed, taxpayers use deductions and losses to reduce their starting 1040 Form “Gross Income” to the lowest “Taxable Income” possible near the bottom of the 1040 form. One of those deductions or “losses” that helps reduce or shield your taxable income is related to real estate rental property operations that are calculated on the schedule E form and flow to your 1040 Form line 17.
Schedule E Mechanics
A rental property owner will fill out their Schedule E with all the property’s income and expense items for the year. The top number is the rental income, then they subtract expenses like maintenance, property taxes, insurance, mortgage interest, and depreciation. If the net number is a loss – which is common for the first bunch of years after a property is acquired – that loss generally goes onto the 1040 Form line 17 and is a reduction of one’s personal income. That reduction flows through their entire 1040 form to reduce their taxable income and hence reduces the amount of taxes one would pay Uncle Sam.
And that’s how real estate saves you money on taxes; by allowing you to take a rental property deduction to reduce your gross income by the amount of any losses you incur on your real estate ownership. If you have a ($10,000) loss, you can shield $10,000 worth of your income from taxation which could save you $2,500 to $4,500 that year!
Hold on though, guess what, there are some restrictions that the IRS enacted years ago to limit wealthy people from taking too much of an advantage of these tax saving measures.
These restrictions are generally called passive activity loss (PAL) limitations and most investors’ rental property operations are “passive activities” under the IRS code. The first PAL limitation restricts the maximum allowed net PAL that an individual can use to ($25,000) per year. So if one has a loss of ($35,000), they can use ($25,000) but have to carry the extra ($10,000) forward, probably for years, until it can be used down the road within the annual ($25,000) limit. Additionally, the ability to use any losses at all phases out as an investor’s Adjusted Gross Income (AGI) goes from $100,000 to $150,000 – at which point they can’t use the losses at all in the current year and would need to carry them over, possibly for decades, until their income drops below those levels.
So if you have huge losses, and/or your AGI is over $150,000 you’re probably out of luck on using significant losses to shield your income from taxation – discuss with your tax professional.
One last quirk in this law is that if the property owner is a real estate professional, check the tax code for qualifications, the ($25,000) PAL limitation might not apply. Now you might think that real estate professionals would be savvy enough investors to buy properties that don’t have huge tax losses, but I see investors do the darnedest things all the time! For yourself, try to buy good cash flow positive properties first, and then you won’t come up upon those PAL limits because your losses should be relatively small.
To summarize, if you are going to buy rental properties, and you are counting on the tax benefits to help your investment returns, make sure to get with your tax advisor beforehand to look at your entire tax picture. This will hopefully ensure you will actually earn some tax savings due to your real estate ownership; because, as with everything in real estate, tax savings are not as simple as just buying and assuming everything will work out to your favor!